INTERNAL REVENUE SERVICENATIONAL OFFICE TECHNICAL ADVICE MEMORANDUM

December 11, 2001

Number: 200213010Release Date: 3/29/2002Index (UIL) No.: 163.12-00; 264.00-00CASE MIS No.:

Taxpayer's Name:

Taxpayer's Address:

Taxpayer's Identification No: Years Involved: Date of Conference:

LEGEND:

Taxpayer =

Sub = Insurer = Regulator = Administrator A = Administrator B = Actuary A = Actuary B = Analyst = P1 = P2 = Year 1 = Year 2 = Year 3 = Year 4 = Year 5 = Year 6 = Year 7 =

2

Year 8 = Year 9 = Year 10 = Year 11 = Year 12 = Year 13 = Year 14 = Year 15 = Year 72 = Month A = Month B = Month C = Month D = Month E = Date 1 = Date 2 = Date 3 = Date 4 = Date 5 = Date 6 = Date 7 = Date 8 = Date 9 = Date 10 = Date 11 = Date 12 = Date 13 = State A = State B = State C = Number A = Number B = Number C = Number D = Number E = Number F = Number G = Number H = Number J = $a = $b = $c = $d = $e = $f = $g =

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$h = $j = $k = $m = $n = $p = $q = $r = $s = $t = $u = $v = $w = $x = $y = $z = $aa = $bb = $cc = $dd = $ee = $ff = $gg = $hh = $jj = $kk = a% = b% = c% = d% = e% = f% = g% = h% = j% = k% = m% = n% = p% = q% = r% = s% = t% = u% = v% = w% =

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1 Unless otherwise indicated, section references are to the Internal RevenueCode of 1986 and the accompanying regulations, as amended and in effect during thetaxable years at issue.

2 In 1997, Congress redesignated former § 264(c)(1) as § 264(d)(1). See Pub.L. No. 105-34, § 1084(a)(2), 111 Stat. 788, 951 (1997). Since the first seven policyyears of the P1 and P2 policies occurred prior to 1997, we refer to the four-out-of-seventest in former § 264(c)(1).

x% =

ISSUES:

1. Whether Taxpayer’s two broad-based corporate-owned life insurance (“COLI”)programs, plans P1 and P2, were shams in substance, thereby precludingTaxpayer from claiming deductions under I.R.C. § 163 with respect to interestexpenses incurred on policy loans.1

2. Whether Taxpayer paid four of the first seven years’ annual premiums for itsCOLI policies by a means other than indebtedness, thereby satisfying the “four-out-of-seven" safe harbor set forth at former § 264(c)(1) and the accompanyingregulations.2

CONCLUSIONS:

1. Taxpayer purchased its COLI programs pursuant to a plan that lacked objectiveeconomic substance and lacked subjective business purpose. We conclude thatTaxpayer's broad-based P1 and P2 plans were shams in substance. Therefore,Taxpayer is not permitted to claim interest deductions pursuant to § 163 withrespect to interest incurred on the COLI policy loans during the years in issue.

2. Taxpayer satisfied the four-out-of-seven safe harbor set forth at § 264(c)(1). Although Taxpayer received refunds of premiums with respect to the P2 planpolicies, this did not result in a “substantial increase” in premiums that requiresthe seven-year testing period to begin anew. Moreover, Taxpayer’s receipt ofcertain experience-based premium refunds with respect to the second throughfourth years of the P2 plan policies did not cause borrowing in those years toexceed premiums for purposes of Treas. Reg. § 1.264-4(d)(1)(ii), since thatprovision generally requires that premiums be determined without regard to suchexperience-based refunds. Thus, no portion of Taxpayer’s borrowing in thesecond through fourth policy years can be allocated to the first policy year. Lastly, the retroactive attachment of the fixed interest rate rider to the P1 planpolicies did not change the terms of the policies to a degree sufficient to requirea new 7-year testing period for those policies. Although we conclude thatTaxpayer has satisfied the four-out-of-seven safe harbor, Taxpayer may not

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3 For convenience, we refer to both Taxpayer and its predecessor company as“Taxpayer.”

4 The premiums for both term and whole life policies also include, in addition toCOI charges, amounts to pay for the insurer’s administrative costs and to provide theinsurer with a profit.

deduct interest on policy loans because the P1 and P2 plans as a whole wereshams in substance for purposes of § 163.

FACTS:

The taxable years in issue are Years 11 through 15. During those years, Taxpayer’spredecessor company was a public utility organized under the laws of State A andregulated by Regulator, which regulated public utilities in State A.3 This case arises outof Taxpayer’s participation in a highly leveraged broad-based COLI program, whereinTaxpayer purchased life insurance policies on the lives of Number A of its employees. Taxpayer purchased the policies as part of two separate plans: (1) the P1 plan, whichTaxpayer purchased in Month A, Year 2, comprised of Number B policies; and (2) theP2 plan, which Taxpayer purchased in Month B, Year 3, comprised of Number Cpolicies. Taxpayer was the beneficiary of these life insurance policies.

Background of Life Insurance

Due to the complexity of the P1 and P2 plans, we shall first explain the basic principlesof life insurance before discussing the specific facts in this case. There are two types oflife insurance policies: (1) term insurance policies, which provide a death benefit for aspecified term of years; and (2) whole life insurance policies, which provide a deathbenefit throughout the life of the insured. Insurers determine the premium charged forterm insurance policies on the basis of the actuarially-calculated cost of providing thespecified death benefit during the term of the policy. This cost, which varies on thebasis of the insured’s age and the size of the death benefit, is referred to in theinsurance industry as the cost of insurance (“COI”). Insurers determine the premiumcharged for whole life insurance policies on the basis of the actuarially-calculated costof providing death benefits throughout the insured’s life. Thus, the premiums chargedfor a whole life insurance policy during earlier policy years typically involve a prefundingof COI charges for later policy years. Due to this prefunding of future mortality costs,the policyholder of a whole life insurance policy may accumulate and invest a portion ofits premium payments in an account referred to as the policy’s “cash value.”4 Incontrast, term life insurance policies typically have no cash values. See generallyKenneth Black, Jr. and Harold D. Skipper, Jr., Life Insurance 82-83, 98-99 (PrenticeHall 12th ed. 1994).

The insurance company will increase accumulated cash value by crediting to thepolicyholder amounts in the nature of interest; in this sense, the policyholder’s cash

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value is similar to an interest-bearing bank account. The source of these additionalcredits is the income generated by the insurance company’s investments. Thisadditional contribution to the policyholder’s cash value is referred to as “inside buildup.”

The owner of a whole life policy may use loans or withdrawals to access the policy’scash value during the insured’s lifetime. Policy loans are typically structured as a loanfrom the insurance company to the policyholder, with the policy’s cash value serving ascollateral for the loan. The loan is deemed to have been made from the general assetsof the insurance company, not as a withdrawal from the accumulated cash value of thepolicy. If the insured dies before the loan is repaid, the amount of the loan and accruedloan interest is deducted from the death benefit payable under the policy. Policywithdrawals, whereby the policyholder withdraws a portion of the cash value, maysimilarly reduce the death benefit; however, in contrast to policy loans, the policyholderhas no obligation to repay amounts withdrawn.

There are two primary tax benefits arising from the ownership of life insurance policies:(1) taxpayers may defer tax on their policy’s inside buildup; and (2) taxpayers mayexclude from income any death benefits received pursuant to § 101(a). In addition,policyholders may in certain instances deduct interest incurred on policy loans. Thiscombination of deferral of taxation of inside buildup, the exemption of taxation of deathbenefits, and the deductibility of interest on policy loans has historically created theopportunity for tax arbitrage by policyholders. By using an asset that produces tax-deferred income as security for a loan, a taxpayer is able to deduct interest incurred onthe loan while the secured asset increases in value tax free.

With these concerns in mind, Congress in 1964 enacted limitations on the deductibilityof policy loan interest. Particularly, Congress amended § 264 to provide that nodeduction is allowed for amounts paid or accrued on indebtedness incurred orcontinued to purchase or carry a life insurance contract pursuant to a plan of purchasewhich contemplates the systematic borrowing of part or all of the increases in the cashvalue of such contract. § 264(a)(3) (1964). Congress also enacted an exception to thisgeneral disallowance rule with respect to interest paid or accrued on policy loansincurred or continued as part of a plan whereby no part of 4 of the first 7 annualpremiums due on the contract is paid by means of indebtedness. § 264(c)(1) (1964). This safe harbor is commonly referred to as the “four-out-of-seven” safe harbor. Legislative history reflects that Congress enacted these provisions with a concern thatsome insurance companies were marketing insurance policies to individuals primarilyas tax-saving devices. S. Rep No. 88-830 (1964), reprinted in 1964-1 C.B. (Part 2) 505,581-582. Congress also explained that it fashioned the four-out-of-seven safe harbor,in part, to preserve the value of life insurance generally by retaining some rights in theindividual to borrow on insurance, as one could in the case of other assets. Id. at 583.

Congress’ efforts in 1964 did not end the use of tax arbitrage associated with lifeinsurance. Corporations began purchasing COLI on the lives of their employees as ameans of generating large policy loans, interest deductions, and tax savings. Congress

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5 In 1986, Congress also enacted § 163(h) (1986), which disallows deductionsfor personal interest. Consequently, life insurance tax arbitrage plans were no longermarketed to individual taxpayers after the effective date of this legislation, sinceindividuals could no longer deduct interest incurred on policy loans.

6 We note that Taxpayer purchased the P1 and P2 plans prior to the June 20,1986, effective date of the $50,000 per policy limitation. Nevertheless, given thenumber of policies that Taxpayer purchased, we consider Taxpayer’s COLI programs tobe broad-based.

7 Taxpayer also provided death benefits to employees who died prior toretirement.

in 1986 attempted to address this perceived abuse by eliminating the interest deductionon policy loans to the extent that the aggregate indebtedness exceeds $50,000 peremployee, effective June 20, 1986. § 264(a)(4) (1986).5 The Joint Committee onTaxation Staff, in explaining reason for this provision, stated: “Congress did not intendto allow these loans to be an unlimited tax shelter as under prior law.” See Staff ofJoint Comm. on Taxation, 100th Cong., 1st Sess., General Explanation of the TaxReform Act of 1986 579 (Comm. Print 1987).

In an attempt to circumvent the $50,000 per policy limitation, insurance industryspecialists marketed “broad-based” COLI programs in which a corporation purchasesinsurance on thousands of its non-executive employees, regardless of the value of theemployees’ services to the corporation.6 Thus, by increasing the number of policiesissued in the COLI plan, the corporation could increase aggregate policy loans and loaninterest deductions while remaining within the $50,000 per policy loan limit. In 1996,Congress, believing that these broad-based COLI programs were inappropriate, onceagain amended § 264 by entirely eliminating the availability of policy loan interestdeductions generated by COLI programs, except for certain key person insuranceprograms. § 264(a)(4), (d) (1996). The Joint Committee on Taxation, in explaining thepurpose of the legislation, particularly noted Congress’ concern for transactions inwhich taxpayers borrow against the value of their policies at an interest rate only slightlyhigher than the interest rate at which the insurer credits inside buildup to the policies. See Staff of Joint Comm. on Taxation, 104th Cong., 2d Sess., General Explanation ofTax Legislation Enacted in the 104th Congress 363-364 (Comm. Print 1996). The JointCommittee also explained that Congress, in amending § 264, did not intend thattaxpayers make inferences concerning the deductibility of policy loan interest paid orincurred prior to the effective date of the 1996 legislation. Id. at 367.

Taxpayer’s COLI Transactions

Taxpayer, when it began considering the P1 and P2 plans, provided life insurancebenefits to its retired employees in the amount of % of a retired employee’s salaryas of the date of retirement.7 Taxpayer paid for these benefits as part of a “pay-as-you-

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8 Taxpayer refers to these pay-as-you-go programs as “cost plus” plans,whereby Taxpayer pays the administrator for the cost of accrued death benefits, plusadministrative expenses.

9 This liability fluctuated on the basis of the number of eligible employees andwage inflation.

go” program administered by Administrator A, and recovered the cost of the benefitsfrom its customers through the rates set by Regulator.8 In Year 1, a life insurancebroker (“Broker”) who was developing Taxpayer’s executive compensation plansadvised Taxpayer that Taxpayer faced a large unfunded liability attributable to the lifeinsurance benefits provided to its retired employees. In Year 1, Broker estimated theliability at approximately $a; by the following year, Broker’s estimate had grown to $b.9 Broker recommended that Taxpayer fund the liability by purchasing COLI on the lives ofsome of its employees, naming Taxpayer as the beneficiary. Taxpayer rejectedBroker’s proposal due to concerns over the proposal’s regulatory treatment andfinancial feasibility.

During Year 2, Broker attempted to reduce Taxpayer’s post-retirement life insuranceliability by advising Taxpayer to create a new benefits program whereby Taxpayer’semployees aged years or older would retain eligibility for post-retirement lifeinsurance benefits, but employees younger than age would not be eligible for suchbenefits. Broker further recommended that Taxpayer switch the plan administrator fromAdministrator A to Administrator B, but continue to pay for the program on a pay-as-you-go basis. Broker’s goal was to address both Taxpayer’s liability and Taxpayer’sconcerns regarding Administrator A’s expenses and customer service problems. Inconjunction with these proposals, Broker also offered to Taxpayer a new COLI planwhereby Taxpayer would purchase whole life insurance on its employees aged years or older. Broker suggested that the cost of the COLI plan be paid by Taxpayer’sshareholders, rather than through Taxpayer’s rate base.

Broker requested Actuary A, an actuarial consulting firm, to review Broker’s proposal toTaxpayer. By letter to Broker dated Date 1, Year 2, Actuary A explains that thepurposes of the proposed COLI plan were to fund: (1) one-half of the death benefitspayable to active employees aged and over; (2) all of the post-retirement deathbenefits for current employees aged or older; and (3) all of the death benefits forexisting retirees, who were nonetheless not lives actually insured under the proposedpolicies. An appendix attached to the letter contains four individual policy illustrationsthat describe a plan whereby Taxpayer pays four out of the first seven annualpremiums in cash, pays the remaining three premiums through policy loans, borrowsheavily from the policies’ cash value in each policy year after the seventh, and deductspolicy loan interest for Federal income tax purposes at a bracket of 49%. Actuary Aconcludes that Broker’s proposal, “when viewed as an investment,” produces a netafter-tax rate of return to Taxpayer over the life of the policies in the amount of a%.

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10 Taxpayer is unable to locate the original policy illustrations underlying the P1plan.

11 Broker’s projected liability is between $f and $g, with an anticipated liability of$h.

Specifically, Actuary A explains: “The large write-off of the life insurance program hascreated a tax savings which substantially reduces the cost of the [employee benefits]program.”

Taxpayer initially agreed with Broker’s advice, switching its benefit plan administrator toAdministrator B, and purchasing a COLI plan, which it identified as “P1,” in Month A,Year 2.10 Taxpayer, however, did not implement Broker’s advice to stop providing post-retirement life insurance benefits for employees aged younger than years. The P1plan was comprised of Number B policies insuring employees aged years or older,had a total face value of $c, and an annual premium of $d. The policies were written byInsurer, a company with a home office in State B. The P1 policies were held by a StateB Multiple Employer Trust, and Taxpayer was issued trust certificates representingTaxpayer’s ownership interest in the policies.

Broker in Month C, Year 3, proposed that Taxpayer purchase from Insurer an additionalCOLI plan beyond the P1 plan coverage that Taxpayer purchased in Month A, Year 2. Broker prepared a written proposal, dated Date 2, Year 3, with a supplement datedDate 3, Year 3, in an attempt to convince Taxpayer to purchase the additionalinsurance. The proposal explains that, prior to purchasing the P1 plan, Taxpayer haddecided to reduce its potential post-retirement death benefit liabilities by implementing a“new” post-retirement benefits program, into which all existing employees could opt. Particularly, the proposal notes that, prior to purchasing the P1 plan, Taxpayer hadinitially agreed with Broker’s advice to limit eligibility in the existing benefits program toemployees aged and over, but eventually decided to allow all existing employees theopportunity to remain in the existing plan due to “moral or perhaps legal agediscrimination” concerns.

With respect to Taxpayer’s purchase of an additional COLI plan, Broker’s proposalspecifically sets forth: (1) an estimate of Taxpayer’s liability for post-retirement deathbenefits, based on various assumptions regarding the rate of salary increase, attrition,and the number of employees electing to forgo post-retirement benefits to joinTaxpayer’s new post-retirement benefit program;11 (2) a proposed COLI plan in whichTaxpayer will purchase an additional Number D policies with an initial face amount of$e each, whereby Taxpayer will pay premiums in the first, fifth, sixth, and seventh policyyears, borrow heavily from the policy cash values to pay premiums for the second, third,

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12 Taxpayer purchased nearly four times more than the number of policiesrecommended in the proposal.

13 Broker’s 30-year projected after-tax cash flow is between $j and $k,depending upon Taxpayer’s desired “funding level” for the proposed plan. Broker’s low-end estimate of after-tax cash flow is more than two times greater than $g, Broker’shigh-end estimate of Taxpayer’s post-retirement death benefit liability.

14 Taxpayer is unable to locate the original policy illustrations underlying the P2plan.

fourth, and eighth policy years, and all policy years thereafter;12 (3) anticipated cashflows from the proposed COLI plan projected over 30 years and expressed in terms of“after-tax outlays,” rather than in terms of death benefits receivable;13 and (4) aninternal rate of return analysis of various COLI products offered by different companies. Broker’s proposal does not indicate that the anticipated death benefits payable from theCOLI policies would be fashioned to correspond with Taxpayer’s liability to pay deathbenefits to its retired employees.

Regarding the timing of Taxpayer’s proposed purchase of the new COLI plan, Broker’sproposal also recommends that “[i]t would be ideal to wait until the fall of [Year 4] toexactly measure the liability and increase the reinsurance funding at that time; however,imminent tax law changes are anticipated.” In this vein, Broker’s proposal explains thatInsurer will allow cancellation of the new COLI plan, less commissions and “puremortality charges,” if tax laws are enacted that adversely affect the designed operationof the plan. On Date 4, Year 3, Insurer’s Senior Vice President sent to Taxpayer a“honeymoon letter” regarding pending tax legislation affecting COLI. The letter states:

This is to assure you that in the event legislation affecting policyholdertaxation is enacted and is effective prior to [Date 5, Year 4] which in theopinion of [Taxpayer] is substantially adverse, we will do all in our powerto provide an alternate funding vehicle for you. . . . If it remainsimpossible to amend the policy or provide an alternate funding vehicle . . .[Insurer] will allow immediate cancellation. . . . [P]remiums will berefunded at that time [to the extent that premiums] are in excess of theterm cost of providing protection from the effective date of the policies tothe date of cancellation. . . .

Soon after receiving Broker’s proposal, Taxpayer purchased an additional COLI plan,identified as “P2,” which was comprised of Number C policies insuring Taxpayer’semployees between the ages of and .14 The policies were written by Insurer, andhad an initial total face value of $m and annual premiums of $n. In similar fashion tothe P1 policies, the P2 policies were held by a State B Multiple Employer Trust, andTaxpayer was issued trust certificates representing Taxpayer’s ownership interest in the

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15 For example, a policy covering -year old participant in the P2 plan wassubject to a $p monthly expense charge in the first policy year, and a $q monthlyexpense charge for policy years two through ten.

16 The percentage expense charge for the P1 policies ranged from d% to e%,based on the policy year and age of the participant. The percentage expense chargefor the P2 policies were solely determined on the basis of policy year, as follows: f% forpolicy year one; g% for policy years two through five; h% for policy years six throughten; and j% for each year thereafter.

policies. Even after purchasing the P1 and P2 plans, Taxpayer maintained the pay-as-you-go program administered by Administrator B.

Features of the P1 and P2 Policies

The P1 and P2 policies were whole life policies with level premiums until age 100 andan initial face amount of $e for each life. The death benefits payable under the P1 andP2 policies increased annually; however, the annual death benefit for the P2 policiesincreased by approximately b%, while the annual death benefit for the P1 policiesincreased by approximately c%. Moreover, the annual death benefit increases for theP2 policies continued to the end of the contract, whereas the death benefit increasesfor the P1 policies continued only until age .

The COI under the P1 and P2 policies was determined on the basis of the age of eachparticipant, the monthly cost of insurance rates per $1,000 of coverage, and theguaranteed death benefit factor set forth on each policy’s data page. In addition to theCOI charges, Insurer imposed several other charges, including: (1) a front-loadedexpense charge imposed only during the first ten policy years, based on theparticipant’s age at the inception of the policy, with an initial charge imposed during thefirst policy year and a lower charge imposed during policy years two through ten;15 (2) apercentage expense charge, which was a contractually-fixed percentage of the annualpremium as stipulated on the data page of each policy;16 and (3) a flat fee for eachpolicy in force at the beginning of the policy year in the amount of $r for each P1 policyand $s for each P2 policy.

The P2 plan also contained provisions whereby Taxpayer could receive premiumrefunds on the basis of the following: (1) a first year policy volume discount equaling k%of gross premiums payable for that year; (2) a “guaranteed mortality profit contribution”refund payable for the first five policy years; and (3) a “fluctuation reserve contingencypayment” in effect throughout the term of the policies. The k% volume premiumdiscount reduced the premiums payable for the first policy year from $t to $u. The othertwo refund provisions were based on the actual claims experience of the P2 policies. The guaranteed mortality profits contribution was equal to m% of the difference

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17 Thus, if the cost of insurance charges were $100, and the death benefitspayable was $90, the refund to Taxpayer under the mortality profit contributionprovision was m% of $10.

18 A basis point is equal to one hundredth of one percent.

19 The policy forms provided that “if any part of the Total Cash Value is subjectto a loan, the interest rate applicable for that part of the Total Cash Value shall be at arate which is [Number G basis points for the P1 plan and Number H basis points for theP2 plan] less than the loan interest rate in effect.”

between the cost of insurance and death benefits paid.17 The fluctuation reservecontingency payment, although involving an elaborate calculation, was similarlydesigned to refund to Taxpayer a portion of the excess of actual claims paid over thecost of insurance, particularly after the fifth policy year.

Since the P1 and P2 policies were whole life insurance policies, Taxpayer was eligibleto obtain policy loans from Insurer, and Insurer credited the policies’ cash value withinside buildup. The policies provided for three relevant interest rates: (1) the interestrate that Taxpayer paid on policy loans; (2) the “loaned crediting rate,” which was therate at which Insurer would credit the portion of the policies’ cash value that was usedto secure policy loans; and (3) the “unborrowed crediting rate,” which was the rate atwhich Insurer would credit the portion of the policies’ cash value that was not used tosecure policy loans. Taxpayer could borrow up to n% of the cash value from the P1policies, and p% of the cash value from the P2 policies; thus, the principal and interestaccrued and unpaid on policy loans could not exceed the policies’ cash value. Taxpayer could repay policy loans at any time, but the loans did not have to be repaiduntil the death of the insured party.

Under the provisions of the policies, Taxpayer was eligible to choose annually from oneof two policy loan interest rate options: a “variable” option, and a “fixed” option. Underthe variable option, Taxpayer would pay an interest rate on policy loans determined bythe “Moody’s Corporate Bond Yield Average,” published by Moody’s Investors Service,Inc., as of two months before the plan anniversary. If the Moody’s rate had notfluctuated more than Number F basis points during the policy year, then the prior year’srate would apply.18 If Taxpayer chose the variable option, Insurer guaranteed that theloaned crediting rate would be equal to Number G basis points less than the policy loanrate for P1 policies, and Number H basis points less than the policy loan rate for P2policies.19 Accordingly, regardless of the interest rate applicable to policy loans underthe variable option, Taxpayer’s actual cost of borrowing remained constant becausethere was a pre-determined “spread” between the loan interest rate and the loanedcrediting rate. Under the fixed option, Taxpayer could elect to pay interest on policyloans at a rate equal to the Moody’s Corporate Bond Yield Average rate in effect twomonth prior to the policies’ issue date, but the loaned crediting rate was “declared” by

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20 Specifically, the policy forms for the fixed rate rider provided that “if any part ofthe Total Cash Value is subject to a loan, the interest rate credited on that part of theTotal Cash Value shall be an effective rate of interest of [q% for the P1 plan and c% forthe P2 plan] or any higher rate set by us.”

Insurer and not expressly guaranteed.20 The fixed option was attached as a rider to theP2 policies when those policies were issued, and was retroactively attached to the P1policies at the same time.

Approximately four months after Taxpayer purchased the P2 policies, Broker sent aletter to Taxpayer, dated Date 6, Year 3, which explains the tax and regulatorymotivations underlying the fixed and variable interest rate options. In relevant part, theletter provides:

An insurance company can only guarantee in the policy the actuarial ratesthat are used to generate the values of the policy. An obvious problemarises when a variable loan interest rate policy is used.

* * * * *

Another constraint is an income-tax issue. . . .

* * * * *If, for example, the Moody’s rate at policy issue was 12% and the currentrate was 10%, how can a taxpayer justify paying the high rate? TheInternal Revenue Service easily could disallow the deduction as simplybeing for tax purpose [sic] only. Why else would you pay more interestthan you had to?

The solution to these issues is an annual option that [Taxpayer] will have.

Option A [Variable Rate Option]– Loan interest rate determined by Moody’s– Spread on [P1] [Number G] basis points– Spread on [P2] [Number H] basis points

OR

Option B [Fixed Rate Option]– Loan interest rate equal to rate in effect at issue– Spread not a guaranteed rate, but rather a declared rate

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21 It appears that the “model law constraints” that Broker refers to are those setforth by the National Association of Insurance Commissioners (“NAIC”) Model PolicyLoan Interest Rate Bill, which the NAIC first adopted in 1981. See 1981 Proceedings ofthe National Association of Insurance Commissioners, I, pp. 47, 51, 421, 517, 534, 535-536. Section 3(B) of the model bill limits the interest rate charged on policy loans to thehigher of: (1) Moody’s Corporate Bond Yield Average for the calendar year ending twomonths before the date on which the policy loan interest rate is determined; or (2) therate used to compute cash surrender values under the policy during the applicableperiod plus one percent per annum. State B adopted these model bill provisions priorto the issuance of the P1 and P2 policies. See State B Code § Number E (imposingpolicy loan interest rate limitations effective [prior to Year 2]). Insurer, by annuallydeclaring the loaned crediting rate under the fixed rate option, ensured that Taxpayercould incur a policy loan interest rate that exceeded the Moody’s Average rate then ineffect without violating the model bill.

This solution solves [Insurer’s] dilemma because they are notguaranteeing rates in excess of model law constraints.21

This solution solves [Taxpayer’s] potential tax issues because you canjustify paying the higher loan interest because at the time of your decisionyou did not have a guarantee of what rate would be credited. There wasa risk element to justify your higher interest expense.

If interest rates rise above the levels at issue, the contractual provision willapply (Option A), and Option B won’t be necessary.

Although the fixed interest rate option did not expressly guarantee a specific loanedcrediting rate due to state regulatory concerns, Taxpayer and Insurer understood that ifTaxpayer elected the fixed rate option, Insurer would use a loaned crediting rate thatproduced the identical pre-determined spread that was expressly available under thevariable interest rate option, i.e., Number G basis points for the P1 policies and NumberH basis points for the P2 policies. Concerning the manner in which Insurer intended toexercise its discretion to declare a loaned crediting rate if Taxpayer elected the fixedinterest rate option, Broker’s Date 6, Year 3 letter further explains:

[T]he bottom line of all of this is the arbitrage could be reduced if [Insurer]chose to treat [Taxpayer] badly. This is extremely unlikely . . . . Theycould only treat [Taxpayer] badly once and on subsequent anniversary[Taxpayer] could choose Option A or drop the policy.

Therefore, the purpose of the fixed rate rider was to create a floor, rather than a ceiling,on the rate of interest that Taxpayer paid on policy loans. Since Taxpayer’s actual costof borrowing was reflected in the pre-determined spread between the policy loaninterest rate and the loaned crediting rate, Taxpayer had no economic incentive to

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reduce the rate of interest imposed on policy loans. To the contrary, Taxpayergenerated more policy loan interest deductions by paying a higher rate. If interest ratesdecreased after the policies were issued, Taxpayer could elect the fixed rate option,thereby generating higher policy loan interest deductions than would be available underthe variable option. Given the interest rates in effect when the policies were issued, thefixed rate option ensured the Taxpayer would pay interest on P1 policy loans at nolower than r%, and on P2 policy loans at no lower than s%.

Taxpayer’s Administration of the P1 and P2 Policies

The following tables summarize Taxpayer’s actual cash flow resulting from the P1 andP2 plans, from their inception through the taxable years at issue:

P1 Plan (dollars in thousands)

Policy YearEnding

Premiums(A)

PolicyLoans(B)

LoanInterest(C)

Net DeathBenefits(D)

Pre-TaxCash Flow(B+D-A-C)

TaxSavings(E)

Net After-Tax CashFlow(B+D+E-A-C)

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22 The term “net equity” refers to a policy’s cash surrender value, less any loansor interest accrued on loans secured by the policy.

P2 Plan (dollars in thousands)

Policy YearEnding

Premiums(A)

PolicyLoans(B)

LoanInterest(C)

NetDeathBenefits(D)

Pre-TaxCashFlow(B+D-A-C)

TaxSavings(E)

Net After-Tax CashFlow(B+D+E-A-C)

The tables reflect that, consistent with Actuary A’s illustrations concerning the P1 planand Broker’s proposal concerning the P2 plan, and in an effort to comply with the “four-out-of-seven” safe harbor set forth in § 264, both the P1 and P2 plans were structuredso that Taxpayer would pay out-of-pocket for premiums in the first, fifth, sixth, andseventh policy years, and borrow from policy cash values to pay premiums for thesecond, third, fourth policy years. The plans were further designed so that Taxpayercould borrow against most of the policies’ remaining cash values in the eighth policyyear and all policy years thereafter. As of Date 11, Year 15, Taxpayer’s total net equityin the P1 and P2 policies was $v, representing t% of the total gross cash value of thepolicies.22

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23 As explained infra, several years after purchasing the P1 and P2 plans,Taxpayer began recovering from its ratepayers the cost of providing post-retirementdeath benefits.

As explained, the P2 plan contained provisions whereby Taxpayer could receivepremium refunds in certain instances. Taxpayer received the following premiumrefunds during the first seven years of the P2 policies (dollars in thousands):

Policy Year Ending Gross Premium Volume DiscountRefund

GuaranteedMortality Refundand FluctuationReserveContingencyRefund

Net Premium

After purchasing the P1 and P2 plans, Taxpayer formed a subsidiary, Sub, for thepurpose of holding the ownership certificates for the P1 and P2 policies. Taxpayercapitalized Sub with $w in cash, and transferred to Sub its ownership interest in the P1and P2 policies. The $w payment was in an amount calculated to allow Sub to pay forfurther anticipated premiums and policy expenses through Month B, Year 9, the end ofthe seventh policy year for the P2 policies, after which Taxpayer anticipated that the P1and P2 policies would pay for themselves and provide net excess cash for Taxpayer’suse.

Taxpayer did not recover the initial costs of the P1 and P2 policies from its ratepayers;thus, Taxpayer’s shareholders paid the up-front cost associated with the COLI plans. Moreover, Taxpayer’s shareholders, not the ratepayers, paid the pay-as-you-go cost ofTaxpayer’s post-retirement death benefit program after Taxpayer purchased the P1 andP2 plans.23 Taxpayer further intended that any after-tax benefits generated by the P1and P2 plans, net of the pay-as-you-go cost of its post-retirement death benefitprogram, be directed solely to its shareholders.

18

On Date 12, Year 4, less than a year after purchasing the P2 plan, Taxpayerimplemented a new employee benefits program. Taxpayer’s new program limitedeligibility for post-retirement death benefits to all of its then active and retiredemployees. This was less restrictive than Broker’s initial recommendation, which wouldhave limited such benefits to active employees then aged or older. Nevertheless,Taxpayer’s new program reduced its projected cost for providing post-retirement deathbenefits. Since the number of participants eligible for post-retirement benefits was fixedas of that date, wage inflation was the only factor that could increase Taxpayer’sliability. Taxpayer’s new program further provided its then active employees with anoption that would provide an increased two-times salary pre-retirement death benefitwhile eliminating post-retirement death benefits. Any then active employees whoexercised this option further reduced Taxpayer’s liability for post-retirement benefits.

In Year 4, Broker retained Actuary B to perform an actuarial study projecting Taxpayer’spost-retirement death benefit liabilities and comparing them to the projected cash flowsfrom the P1 and P2 plans. The study, dated Month D, Year 4, indicated that Taxpayer,in implementing its new employee benefits program, reduced its potential liability forpost-retirement death benefits payable to its then current or retired employees bybetween u% and k%. Additionally, the study calculated the after-tax cash flowsexpected from the P1 and P2 plans under the assumption that Taxpayer would borrowheavily from policy cash values and claim Federal income tax deductions for interestaccrued on policy loans, which, in turn, would generate positive cash flow for Taxpayerby reducing its tax liability. The study sets forth two different illustrations with varyingmarginal federal income tax rates and present value discount factors. The studyconcludes that, as of the beginning of Year 4, the potential gain from the P1 and P2plans, determined by subtracting the present value of future post-retirement deathbenefit liabilities from the present value of future after-tax earnings expected from theP1 and P2 plans, is as follows:

Assuming % Marginal TaxRate and % Discount Rate

Assuming % Marginal TaxRate and % Discount Rate

After-Tax Present Value ofP1 and P2 Plans, IncludingExperience Refunds

Present Value of Post-Retirement GroupLiabilities for Current andFuture Retirees

Net Present Value

According to the actuarial study, the present after-tax value of the P1 and P2 plans asof the beginning of Year 4 was between and times greater than Taxpayer’s

19

projected liability for post-retirement death benefits. In this regard, Actuary B’s studyconcludes:

. . . [Taxpayer] has substantially covered its projected post-retirementliabilities with expected gains from corporate-owned life insurance. As aresult, [Taxpayer] may want to utilize some of the extra gains for coveringthe liabilities of other post-retirement programs.

During the same month in which Actuary B prepared its actuarial study, Brokerprepared a document called “[Sub] Dividend Scenarios,” which explains what Taxpayercan do with the positive cash flows generated by the P1 and P2 plans, payable toTaxpayer in the form of dividends from Sub. Broker suggests that Taxpayer, in additionto using the dividends to pay for post-retirement death benefits, use the dividends for:post-retirement health care costs; executive salary continuation; dividends toTaxpayer’s shareholders; deferred benefits for Taxpayer’s directors; and “other”expenses.

Actuary B’s study also sets forth the following -year projection of “annual after-taxexpected cash flows” from the P1 and P2 policies for Years 2 through 72, assuming a % marginal tax rate and a % interest rate:

(A) Pre-tax cash flow: Loanproceeds and net deathbenefits received, lesspremiums and interestpayable

(B) Tax benefit from interestdeduction

(C) After-tax cash flow: (B - A)

Thus, the projections indicate that, but for the tax benefits derived from policy loaninterest deductions, Taxpayer’s cash flow from the P1 and P2 plans would result in aloss of ($x). The projections further indicate that, except for Years 4 and 10, the P1 andP2 plans would generate negative pre-tax cash flows for each year between Year 2 andYear 72.

Taxpayer has had policy loans outstanding on the P1 and P2 policies during eachpolicy year after the first policy year. Taxpayer has chosen the fixed interest rate optioneach year, and the interest rate Taxpayer has paid on policy loans has exceededmarket interest rates for most of the time that the P1 and P2 plans have been in effect. Consistent with Broker’s assurance reflected in the letter dated Date 6, Year 3, Insurerdeclared a loaned crediting rate under the fixed rate option that produced the identicalpre-determined spread between the policy loan interest rate and loaned crediting rateas was expressly available under the variable rate option, i.e., Number G basis pointsfor the P1 policies, and Number H basis points for the P2 policies. In contrast, the

20

24 Insurer’s portfolio earnings rate represents Insurer’s total net investmentincome divided by the average of the beginning and ending cash and invested assetportfolio balances.

unborrowed crediting rate was based on current U.S Treasury Bill rates, subject to aminimum rate. Therefore, since Taxpayer first began borrowing from the P1 and P2policies, the unborrowed crediting rate has fluctuated on the basis of market conditions,and has always been less than the loaned crediting rate. The following chart reflectsthe P1 and P2 policies’ annual policy loan interest rates, annual loaned crediting rates,annual unborrowed crediting rates, Moody’s Corporate Average Monthly Bond Rates,and Insurer’s annual portfolio earnings rates:24

CalendarYear inwhich policyyear began

P1 Loan interestrate/loanedcrediting rate

P2 Loan interestrate/loanedcrediting rate

Unborrowedcrediting rate (high/low)

Moody’sCorporate Avg.Monthly BondRate (high/low)

Insurer’sPortfolioEarningsRate

The table reflects that, during the five taxable years in issue, Taxpayer paid interest onP1 policy loans at a rate that was between % and % greater than Moody’sCorporate Average Monthly Bond Rates, and paid interest on P2 policy loans at a ratethat was between % and % greater than the Moody’s rate.

As noted previously, the P1 and P2 policies were initially held by a State B MultipleEmployer Trust, and were subject to the laws of State B. In Year 5, however, the fixed

21

25 State B’s usury rate is based on the Federal Reserve Average Prime LendingRate, plus v%.

26 In addition, the after-tax cash flow generated by the P1 and P2 plans continueto be directed to Taxpayer’s shareholders, rather than being used to reduce the ratescharged to its customers. Regulator reaffirmed this in a Year 15 rate case involvingTaxpayer, in which State A’s Consumer Counsel wanted Taxpayer to share Sub’s taxbenefits with its Taxpayer’s ratepayers. Regulator agreed with Taxpayer that the

option policy loan interest rate for the P1 policies exceeded the interest rate permittedunder State B’s usury laws.25 Accordingly, Insurer transferred the master policies to apre-existing Multiple Employer Trust located in State C, where there were no suchrestrictions on policy loan interest rates.

Taxpayer’s Reporting of the P1 and P2 Transactions for Financial Accountingand Regulatory Purposes

When Taxpayer purchased the P1 and P2 plans, for purposes of its financialstatements it accounted for its post-retirement death benefit liabilities on a pay-as-you-go basis, which was consistent with the manner in which Taxpayer paid AdministratorsA and B for those liabilities. In December 1990, however, the Financial AccountingStandards Board (“FASB”) issued Statement No. 106, “Employers’ Accounting forPostretirement Benefits Other Than Pensions” (“FAS 106"). FAS 106, which wasgenerally effective for fiscal years beginning after December 15, 1992, requiresemployers to estimate and accrue the expected cost of providing an employee’s post-retirement benefits during the years in which the employee renders the necessaryservice. Consequently, for financial accounting purposes, Taxpayer could no longeraccrue post-retirement benefits as they arose, but rather, had to accelerate theliabilities while the employees were active. FAS 106 also imposed a “transition cost”attributable to post-retirement liabilities that were deemed accumulated and accruedunder FAS 106, but which had arisen in years prior to implementation of FAS 106 andhad not yet been recorded as an obligation under a pay-as-you-go accounting method.

During Year 10, and after the issuance of FAS 106, Regulator approved a rateSettlement Agreement with Taxpayer that addressed the accounting and regulatorytreatment of Taxpayer’s liabilities for post-retirement benefits. The agreement andsubsequent amended agreements permitted Taxpayer to recover the cost of its post-retirement life insurance liabilities from its ratepayers on a pay-as-you-go basis, andpermitted Taxpayer to amortize and recover from its ratepayers over twenty years anytransition costs resulting from the implementation of FAS 106. Accordingly, theagreement permits Taxpayer to fully recover from its ratepayers the cost of its post-retirement life insurance program. The after-tax cash flow generated by the P1 and P2plans, although initially allocated in part towards the cost of Taxpayer’s post-retirementdeath benefit liabilities, is no longer needed to pay for such liabilities.26

22

ratepayers should not share the benefits, since they did not incur the initial cost of theP1 and P2 plans.

In Month E, Year 12, Taxpayer met with several representatives from bond ratingagencies to discuss Taxpayer’s liabilities for policy loans relating to the P1 and P2plans. Specifically, Taxpayer was concerned about the treatment of those loans forpurposes of its financial ratings. Analyst, Taxpayer’s Financial Analyst who assistedTaxpayer in purchasing the P1 and P2 plans, prepared a document and provided it tothe bond rating agencies. The document explains Sub’s policy loan interest expense asfollows:

[Sub’s] COLI has been grandfathered under the tax laws in effect beforethe Tax Reform Act [“TRA”] of 1986. Under pre-[TRA] rules, interest paidby corporations for loans drawn against insurance policy cash values isfully deductible. The build-up of value inside the insurance policies is taxdeferred and, [sic] since the COLI is held until the death of the insuredindividuals, all income becomes tax exempt. [Sub’s] COLI was designedto take advantage of this imbalance in tax treatment. It is most valuablewhen cash values are routinely borrowed by the policy owner – creating abeneficial tax arbitrage.

[emphasis added]. The document also states:

This is very nearly a self-sustaining cycle: the loans pay the premium andmost of the interest expense; and any out-of-pocket cash needed to makeup the difference comes from the tax benefits derived from the interestexpense . . . . The tax benefits make the difference between self-sustaining and self-liquidating. The only way in which [Taxpayer’s]operations support [Sub] is indirect; [Taxpayer] must have sufficienttaxable income to offset [Sub’s] tax benefits. [Taxpayer’s] operatingincome is otherwise entirely available to support [Taxpayer’s] otherindebtedness.

Taxpayer also made a slide presentation to the bond rating agencies on Date 13, Year12, describing the P1 and P2 policies as “Insurance Designed to be ‘Stripped’” with“Maximum Borrowing” and “Maximum Interest and Tax Benefits.” The slides indicatethat the policies will result in pre-tax losses to Taxpayer, discounted to present value, of($y). The slides further indicate, however, that these losses are offset by the presentvalue of the tax benefits, $z. Moreover, the slides describe Taxpayer’s “WorkingStrategy” in owning the P1 and P2 policies as reducing the tax liability of Taxpayer’sconsolidated group, and as producing cash flows that contribute to the gradual growthof Taxpayer’s core business and new related business.

23

Upon Examination of Taxpayer’s returns for Years 11 through 15 (encompassing policyyears ten through fourteen for the P1 policies and nine through thirteen for the P2policies), the Field concluded that Taxpayer could not claim as deductions for incometax purposes the interest that Taxpayer incurred on loans secured by the P1 and P2policies. The Field has set forth two reasons for the proposed disallowance: (1) the P1and P2 plans were shams in substance for purposes of § 163; and (2) Taxpayer failedto satisfy the four-out-of-seven test set forth in § 264(c)(1).

LAW AND ANALYSIS

1. Whether the P1 and P2 plans were shams in substance, therebyprecluding Taxpayer from claiming deductions under I.R.C. § 163 withrespect to interest expenses incurred on policy loans.

At issue in this case is whether Taxpayer is entitled to claim deductions under § 163(a)with respect to interest incurred on loans secured by the policies that comprised the P1and P2 plans. Section 163(a) provides: "There shall be allowed as a deduction allinterest paid or accrued within the taxable year on indebtedness." Court opinions,however, have established that taxpayers are not entitled to claim interest deductionsunder § 163 if the interest is derived from a sham transaction aimed solely at taxavoidance. See Knetsch v. United States, 364 U.S. 361 (1960); Goldstein v.Commissioner, 364 F.2d 734 (2d Cir. 1966).

The sham transaction doctrine originated in the Supreme Court in Gregory v. Helvering,293 U.S. 465, 469 (1935). In Gregory, the Court denied reorganization treatment withrespect to a stock distribution even though the taxpayers had seemingly complied withthe Code’s requirements concerning reorganizations. The Court, in deciding that thedistribution was taxable as a dividend, concluded that the structure of the transactionwas a "mere device" for the "consummation of a preconceived plan" and not areorganization within the intent of the Code. Id. The transaction, because it lackedeconomic substance, was not "the thing which the statute intended." Id.

Courts have recognized two basic types of sham transactions: shams in fact and shamsin substance. Kirchman v. Commissioner, 862 F.2d 1486, 1492 (11th Cir. 1989). Shams in fact are transactions that occurred only on paper and not in reality, whereasshams in substance are transactions that actually occurred but are lacking in economicsubstance. See ACM Partnership v. Commissioner, 157 F.3d 231, 247 n.30 (3rd Cir.1998). Therefore, a transaction that lacks economic substance is not recognized forFederal tax purposes and cannot give rise to a deductible expense. See United Statesv. Wexler, 31 F.3d 117, 122 (3d Cir. 1994).

The parties in this case do not dispute whether the P1 and P2 transactions occurred;rather, they dispute whether the transactions are shams in substance. Interestpayments, in particular, are not deductible if they arise from transactions lacking

24

“purpose, substance, or utility apart from their anticipated tax consequences." Goldstein, supra, at 740. The fact that an enforceable debt exists between theborrower and lender is not determinative of whether the debtor may deduct interestarising from that debt. See Wexler, supra, at 125. Rather, the transaction as a whole,of which the debt is a part, must have economic substance before the debtor maydeduct the interest. See Winn-Dixie Stores, Inc. v. Commissioner, 113 T.C. 254, 279(1999), aff’d, 254 F.3d 1313 (11th Cir. 2001). Otherwise, every tax shelter, no matterhow lacking in substance, could generate an interest expense deduction as long asthere was a real creditor in the transaction that demanded repayment.

In determining whether a transaction constitutes a sham in substance, both a majorityof the Courts of Appeals and the Tax Court have employed a flexible two-prongedanalysis that focuses on two related factors, economic substance apart from taxconsequences, and business purpose. See ACM Partnership, supra, at 247; Karr v.Commissioner, 924 F.2d 1018, 1023 (11th Cir. 1991); James v. Commissioner, 899 F.2d905, 908-909 (10th Cir. 1990); Shriver v. Commissioner, 899 F.2d 724, 727 (8th Cir.1990); Rose v. Commissioner, 868 F.2d 851, 853 (6th Cir. 1989); Kirchman v.Commissioner, supra, at 1492; Winn-Dixie, supra, at 280-281. Whether a transactionhas economic substance is determined by an objective evaluation of how thetransaction alters the taxpayer’s economic position, aside from tax benefits. SeeKirchman, supra, at 1492. In doing so, it is appropriate to analyze the transaction in itsentirety rather than isolate any single step. Id. at 1493-1494. Whether a transactionhas legitimate business purpose is determined by a subjective analysis of thetaxpayer's intent. See ACM Partnership, supra, at 247.

Three recent court opinions have addressed whether certain broad-based COLItransactions had sufficient economic substance and business purpose to permit theowners of the underlying policies to deduct interest incurred on policy loans under § 163. In each case, the court concluded that the COLI plans at issue lacked economicsubstance and business purpose.

The first of the three courts that have recently addressed broad-based COLItransactions is the United States Tax Court. See Winn-Dixie, supra. In Winn-Dixie, thetaxpayer purchased a COLI plan comprised of 36,000 policies on the lives of itsemployees. The taxpayer purchased the plan pursuant to a pre-arranged schemewhereby the taxpayer would systematically borrow from the policies in order to paypremiums. The taxpayer paid an interest rate of 11.06% on policy loans, and theinsurer provided the taxpayer with a loaned crediting rate of 10.66% on leveraged cashvalues, thereby producing a fixed spread of 40 basis points. In contrast, the insurerprovided the taxpayer with a crediting rate of 4 percent on unborrowed cash values.

The promoters of the COLI plan in Winn-Dixie provided the taxpayer with detailedprojections of costs and benefits expected from the plan over a 60-year period. Particularly, the projections indicated that, during each policy year, the plan would

25

generate a pre-tax loss and a significant after-tax profit, attributable to deductions forpolicy loan interest and administrative fees. The plan contemplated that the taxpayerwould maintain little net equity in the policies, relative to the size of the plan.

The court in Winn-Dixie first addressed whether the COLI plan possessed sufficientobjective economic substance. The taxpayer argued that the COLI plan could producetax-independent benefits if the insureds died earlier than anticipated, thereby producingunexpected death benefits. The court recognized that life insurance may be legitimate,even where its predictable cost exceeds its predictable benefits, if the policy protectsthe beneficiary against the financial consequences of the insured’s untimely death. Thecourt, however, found that the taxpayer did not purchase the plan to provide deathbenefit protection, noting the large number of geographically dispersed insureds andthe fact that the employees remained insured even after their employment wasterminated. Id. at 284-285. The court further observed that, although there would besome variation between the anticipated and actual mortality of the 36,000 insureds,such variations were not expected to significantly affect the plan. Viewing the COLIplan as a whole, and noting the annual discrepancy between pre-tax losses and after-tax profits set forth in the promotional material, the court found that the plan’s onlyfunction was to reduce the taxpayer’s income tax liabilities. Id. at 285. Thus, the courtconcluded the plan lacked economic substance.

The court in Winn-Dixie next addressed whether the taxpayer had a sufficientsubjective business purpose for entering into the COLI transaction. The taxpayerargued that its business purpose for entering into the transaction was to generate fundsto pay for the increasing cost of its employee benefits program, which included limiteddeath benefits. The court rejected this argument, explaining that there was noindication that the COLI policies were tailored to fund the taxpayer’s employee benefitplan, and that employees remained insured after they left the taxpayer’s employ. Id. at286. In addition, the court explained that even if the taxpayer had earmarked the COLIplan’s tax savings to fund its employee benefits, that would not be sufficient to “breathesubstance” into the transaction. Otherwise, reasoned the court, “every sham tax shelterdevice might succeed.” Id. at 287. Moreover, the court noted that the taxpayer wasoffered an “exit strategy” to terminate the plan if new legal limitations were imposedupon taxpayer’s interest deductions, thereby suggesting that the purported businesspurpose for the plan was not sufficient to maintain the plan without the plan’s taxbenefits. Id. at 288-289. Thus, the court concluded that the COLI plan served nobusiness purpose for the taxpayer, other than to reduce its taxes.

The next two opinions that addressed broad-based COLI transactions were In re C.M.Holdings, Inc., 254 B.R. 578 (D. Del. 2000) and American Electric Power, Inc. v. UnitedStates (“A.E.P.”), 136 F. Supp.2d 762 (S.D. Ohio 2001), which involved similar COLItransactions based upon policies issued by the same insurer. In C.M. Holdings andA.E.P., the taxpayers purchased COLI plans comprised of 1,430 and approximately20,000 policies, respectively. The COLI plans in C.M. Holdings and A.E.P., in similar

26

27 The court in C.M. Holdings particularly observed that, even assuming that thetaxpayer’s COLI plan were to generate positive pre-tax cash flows in the fifty-thirdthrough eighty-first years of the plan, it would not confer economic substance upon thetransaction because the taxpayer failed to establish that the aggregate present valuecash flow from the plan provided a “reasonable return in the absence of loan interestdeductions.” See C.M. Holdings, supra, at 631.

28 The court in A.E.P. explained that, although the policy loan interest rate wasvariable, which in turn varied the amount of tax savings derived from the transaction,that fact did “not imbue the plan with economic substance.” A.E.P., supra, at 788.

fashion to the COLI plan in Winn-Dixie, contemplated a scheme whereby the taxpayerswould systematically borrow from the policies to pay premiums. The taxpayers in C.M.Holdings and A.E.P., before purchasing the COLI plans, received financial illustrationsindicating that the COLI plans would generate annual pre-tax losses and significantafter-tax profits, primarily attributable to deductions for policy loan interest. The courtsin both cases described the features of the plans as follows: (1) high policy value on thefirst day of the policy; (2) maximum policy loans used to pay high premiums during thefirst three policy years; (3) zero net equity and maximum borrowing at the end of eachpolicy year, perfected through the use of computer programs; (4) a variable interest rateprovision whereby the taxpayer could choose the interest rate that it paid on policyloans; (5) a fixed spread between the policy loan rate and the loaned crediting rate,“with the counterintuitive result” that the higher the loan interest rate paid by thetaxpayer, the greater the cash flow due to increased tax deductions; and (6) extremelyhigh expense load components for the fourth through seventh policy years, which wereused to create policyholder dividends that could be used to pay premiums. A.E.P.,supra, at 777-778; C.M. Holdings, supra, at 596-597.

In addressing whether the COLI plans at issue lacked objective economic substance,the courts in C.M. Holdings and A.E.P. compared the plans’ economic effects on a pre-tax and after-tax basis. The courts first noted that, according to the financialillustrations provided to the taxpayers before they purchased the COLI plans, the planswere projected to generate negative pre-tax cash flows and positive after-tax cash flowsover the life of the plans.27 The courts further explained that the taxpayers did notexpect to derive material economic gain from the non-tax beneficial components of theCOLI plans, i.e., tax deferred inside build-up and tax-free death benefits. Specifically,the courts reasoned that inside build-up was not a motivating factor since the COLIpolicies were designed to have zero net equity at the end of each policy year. A.E.P.,supra, at 787-788; C.M. Holdings, supra, at 631-632. The courts further noted that thefixed spread between the policy loan interest rate and loaned crediting rate precludedthe taxpayer from receiving any non-tax economic benefit from inside build-up, despitethe fact that the policy loan rates themselves were variable.28 A.E.P., supra, at 788;C.M. Holdings, supra, at 632. In concluding that the taxpayers did not purchase theCOLI plans with an expectation of receiving death benefits, the courts reasoned that the

27

policies were designed to be “mortality neutral,” insofar as the parties expected that thecumulative COI charges paid by the taxpayers would equal the cumulative deathbenefits that the taxpayers would receive. A.E.P., supra, at 787; C.M. Holdings, supra,at 632-635. In addition to addressing whether the taxpayer sought to generate insidebuild-up and receive death benefits in excess of cost, the court in A.E.P. expressedparticular concern that the parties, in designing the policies’ interest rate provisions,exploited a loophole in the NAIC model bill, discussed supra at n.21, in an attempt toensure that the taxpayer would always pay a policy loan interest rate in excess of theMoody’s Corporate Average Rate. A.E.P., supra, at 789-790. In so doing, the courtstated:

When a transaction is structured so that the borrower actually benefitsfrom a higher loan interest rate and the borrower is permitted to [choose]its own interest rate from a range of rates that begins with a rate that farexceeds the industry maximum, the interest rate component of thetransaction lacks economic substance.

Id. at 790. Thus, the courts in C.M. Holdings and A.E.P. concluded that the COLI planslacked economic substance.

The courts in C.M. Holdings and A.E.P. next addressed the parties’ subjective businesspurpose for entering into the COLI transactions. The taxpayer in C.M. Holdings arguedthat it entered into the COLI transaction for the legitimate purpose of providing for theincreasing cost of its employees’ medical benefits, whereas the taxpayer in A.E.P.argued that it entered into the COLI transaction for the legitimate purpose of offsettingthe cost of implementing FAS 106. Both courts rejected the taxpayers’ arguments,emphasizing that the business purpose test is whether the underlying transaction has alegitimate purpose, not whether the taxpayer has a legitimate use for the after-tax cashflows generated by the transaction. A.E.P., supra, at 791-792; C.M. Holdings, supra, at638. The court in C.M. Holdings particularly noted the taxpayer’s concern with pendingtax legislation, manifested by a “honeymoon letter” and an attempt to execute thetransaction before Congressional hearings on COLI began, as further indication that theCOLI plan’s critical feature was its ability to generate interest deductions. C.M.Holdings, supra, at 640. Thus, finding that the earnings generated by the COLI planswere tax-driven, the courts concluded that the plans served no legitimate businesspurpose.

a. Whether the P1 and P2 Plans had Objective Economic Substance

We now address whether the P1 and P2 transactions at issue in this case havesufficient objective economic substance apart from their tax benefits, viewing thetransaction as a whole. Unlike the parties involved in the three published COLIopinions, the parties in this case did not submit precise plan illustrations issuedcontemporaneously with the issuance of the P1 and P2 plans. Nevertheless, other

28

materials dated prior to or recently after issuance of the P1 and P2 plans indicate thatthe primary purpose of the plans was to generate after-tax cash flows for Taxpayerthrough the use of policy loan interest deductions. Actuary A’s illustration, dated justprior to issuance of the P1 plan, refers to the plan “as an investment” based on the“after-tax rate of return” generated by the “large write-off of the life insurance program.” Broker’s Date 2, Year 3 proposal with respect to the P2 plan similarly refers to thebenefits of the proposed plan in terms of “after-tax outlays,” with benefits generated bypolicy loan interest deductions. In this regard, the proposal also assures Taxpayer ofInsurer’s willingness to unwind the transaction in the event that Congress enactsadverse tax legislation, as indicated by the “honeymoon letter,” dated Date 4, Year 3,subsequently provided to Taxpayer by Insurer. Most significantly, Actuary B’s study ofthe P1 and P2 plans dated Month D, Year 4 sets forth the anticipated pre-tax and after-tax effects of the plan, and projects negative pre-tax cash flows from the plans for allbut two of the years between Year 2 and Year 72. Particularly, Actuary B’s studyprojects that, over a -year period, the P1 and P2 plans will result in combined pre-taxlosses of ($x) and positive after-tax cash flows of $aa; this wide difference is primarilydue to the interest deductions generated by policy loan interest deductions. Theprojections in Actuary B’s study are consistent with Taxpayer’s Year 12 description ofthe plans to bond rating agencies as ”Insurance Designed to by ‘Stripped’,” and aspossessing “Maximum Interest and Tax Benefits.” The wide difference in this casebetween anticipated pre-tax losses and positive after-tax cash flows indicates that theP1 and P2 plans lacked economic substance apart from tax benefits. See A.E.P.,supra, at 787; C.M. Holdings, supra, at 625-626; Winn-Dixie, supra, at 283-285.

The policies’ interest rate provisions further indicate that policy loan interest deductionswere the primary feature of the plan. Broker’s Date 6, Year 3 letter to Taxpayerexplains that Insurer fashioned the policies with fixed and variable interest rate optionsso that the interest that Taxpayer paid on policy loans would never decrease after thepolicies were issued; the fixed rate option was available if interest rates decreased, andthe variable rate option was available if interest rates increased. The fixed interest raterider, in particular, exploited a loophole in the NAIC model bill regarding policy loaninterest limitations. By doing so, Taxpayer was able to pay interest on policy loans at arate that far exceeded market interest rates. While Taxpayer paid high interest rates onpolicy loans, Insurer annually declared a loaned crediting rate under the fixed rateoption in an amount that created the same pre-determined spread between the loanedcrediting rate and policy loan interest rate as was available under the variable rateoption. Accordingly, both Taxpayer’s cost of borrowing and Insurer’s profit were fixedregardless of the rate of interest Taxpayer paid on policy loans. The higher policy loaninterest deduction generated by higher policy loan interest charges, coupled with thefixed cost of borrowing, led to the counter-intuitive result that Taxpayer actuallybenefitted more from the transactions on an after-tax basis as policy loan interest ratesincreased. See C.M. Holdings, supra, at 597, 632. Not surprisingly, when the usurylaws of State B threatened to limit policy loan interest rates, the policies weretransferred to a trust administered in State C, where no such limitations existed. As

29

explained by the court in A.E.P., supra, at 790, the interest rate component of atransaction lacks economic substance where the borrower actually benefits from ahigher loan interest rate and the borrower is allowed to choose its own interest rate,including those that far exceed the current market rates.

Taxpayer argues that the P1 and P2 plans had economic substance for four reasons. Taxpayer first argues the transactions materially changed its economic positionbecause Taxpayer had significant cash values in the P1 and P2 policies and had theexpectation of receiving significant death benefits. Specifically, Taxpayer argues that itpaid $bb out-of-pocket for premiums during four of the first seven policy years. Taxpayer further argues that, at the end of the seventh policy years, the policies hadaccumulated death benefit protection of $cc and net equity of $dd. Taxpayer alsocontends that if everyone insured in the P1 and P2 plans died in the same year, it wasentitled to receive death benefits from the policies, net of policy loans, of $ee in the firstpolicy year, increasing to $ff during the sixteenth policy year. Additionally, Taxpayermaintains that, unlike the plans set forth in C.M. Holdings and A.E.P., the P1 and P2plans were not designed to be mortality neutral because Taxpayer expects to receive$gg in death benefits in excess of the COI for the policies. Taxpayer further arguesthat, had it not leveraged the policies, it would receive total death benefits, lessexpenses, in the net amount of $hh.

Taxpayer correctly asserts that the expectation of inside build-up and death benefits aretwo non-tax benefits associated with owning life insurance. Nevertheless, we disagreewith Taxpayer that the P1 and P2 plans provided Taxpayer with any economic benefitsaside from generating tax deductions. Turning first to Taxpayer’s expectation ofaccumulating inside build-up, we note that although Taxpayer temporarily accumulatedcash value by paying cash for four of the first seven years’ premiums, Taxpayer,Broker, and Insurer assumed from the inception of the plans that Taxpayer would havelittle or no net equity in the policies after the seventh policy year. Economic substanceis determined on the basis of the P1 and P2 transactions as a whole, viewed in theaggregate over the life of the plans; we are required to weigh the fact that there wassome economic benefit during any one year of the plan against the economicconsequences of the plan over its duration. See C.M. Holdings, supra, at 629-631. Given the anticipated pre-tax losses that the P1 and P2 plans were expected togenerate over their duration, the fact that Taxpayer generated cash value in the seventhpolicy year does not imbue the plans with economic substance.

Regarding Taxpayer’s expectation of receiving death benefits from the P1 and P2plans, Actuary B’s study projects that the P1 and P2 plans, including expected netdeath benefits received, will result in negative pre-tax cash flows of ($x) over years. We agree with Taxpayer that, in some instances, it is inappropriate to analyze theeconomic benefits of life insurance in terms of pre-tax profit expectations because thepredictable cost of maintaining life insurance may exceed predictable death benefitsand nevertheless be justified by the financial protection that insurance provides against

30

29 We also note that the Guaranteed Mortality Profit Refund and FluctuationReserve Contingency Payments set forth in the P2 policies will reduce any mortalityfluctuations with respect to those policies.

the insured’s untimely death. What Taxpayer actually argues, then, is that its need forfinancial protection against the untimely death of its employees justifies the expectedpre-tax cost of the P1 and P2 plans. In this case, however, Taxpayer purchasedinsurance on a large number of non-executive employees who remained covered evenafter leaving Taxpayer’s employ. Thus, there was little likelihood that expected cashflows from the plan would be significantly affected by discrepancies between theinsureds’ actuarially anticipated mortality used to determined the COI and the insureds’actual mortality. See Winn-Dixie, supra, at 284-285. For that reason, whetherTaxpayer could have generated a windfall from death benefits if many insureds died inthe same year is irrelevant, since the likelihood of such an event is remote. Similarly,although the P1 and P2 plans are not mortality neutral in the same manner as the plansin C.M. Holdings and A.E.P., it is improbable that the actual mortality experience of theP1 and P2 plans will be sufficient to justify the plan’s projected pre-tax cost.29 Accordingly, we disagree with Taxpayer that its expectation of receiving death benefitsconfers economic substance upon the P1 and P2 plans.

We also disagree with Taxpayer’s assertion that, because it would receive deathbenefits in the amount of $hh had it not borrowed from the P1 and P2 policies, the P1and P2 plans possessed economic substance. Taxpayer attempts to analyze theeconomic effects of the transactions by assuming that the policy loans never occurred. This is inconsistent with the economic substance analysis performed by the three courtsthat have addressed COLI transactions. The proper economic substance analysis of aCOLI transaction, as set forth by the courts, is to examine the objective economiceffects of the entire transaction absent its tax benefits. This contemplates comparingthe pre-tax and after-tax consequences of the transaction, including the cost of payinginterest on policy loans. A.E.P., supra, at 787; C.M. Holdings, supra, at 625-626; Winn-Dixie, supra, at 281-285. Accordingly, we reject Taxpayer’s analysis in this respect,which is based upon a non-existent set of facts.

Taxpayer’s second of four arguments is that it had a legitimate non-tax motivation forelecting the fixed rate loan provision, even when it resulted in an interest rate on policyloans that far exceeded current market rates. Specifically, Taxpayer contends:

The [P2] policies purchased in [Year 3] offered a fixed rate rider thatwould permit [Taxpayer] to opt for a constant rate of interest over time.This feature could eliminate nearly all uncertainty from the fundingcapability of the product, and the feature was then added as a rider to the[P1] policies.

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30 Taxpayer’s description of the fixed rate option as providing certain funding forthe plan is also inconsistent with the terms of the fixed rate rider, which permits Insurerto annually declare the loaned crediting rate. This is further indication that Taxpayerand Insurer understood that the annually declared loaned crediting rate under the fixedrate option would produce the identical spread as was expressly available under thevariable rate option.

31 Taxpayer cites the “Blue Book” explanation of certain amendments to § 264 in1996 as indication that Congress approved of fixed loan interest rate provisions withrespect to contracts purchased prior to June 21, 1986. See Staff of Joint Comm. onTaxation, 104th Cong., 2d Sess., General Explanation of Tax Legislation Enacted in the104th Congress 366 (Comm. Print 1996). Specifically, Congress in 1996 imposedlimitations upon the policy loan interest rate that taxpayers could use to generateinterest deductions, and set forth in § 264(e)(2)(B)(ii) an exclusion from such limitationsfor certain contracts with fixed rate provisions purchased prior to June 21, 1986. Inproviding this exclusion, however, Congress did not intend to permit interest deductionsunder § 163 for transactions that otherwise lacked economic substance and businesspurpose. See Winn-Dixie, supra, at 293 (explaining that “we are not persuaded thatCongress, by enacting and amending section 264 . . . , intended to allow interestdeductions under section 163 based on transactions that lacked either economicsubstance or business purpose”). Thus, we must determine whether the P1 and P2transactions as a whole are substantive shams before turning to the legislative historyunderlying § 264.

We disagree. Taxpayer’s actual cost of borrowing was the same under either the fixedor variable rate option, i.e., the pre-determined spread of Number G basis points for theP1 policies and Number H basis points for the P2 policies. We fail to see how the fixedrate option provided Taxpayer with more certain funding in comparison to the variablerate option, unless one considers the certainty of tax benefits generated by policy loaninterest paid at a fixed rate regardless of current market conditions.30 Indeed, a fixedloan rate provision would serve a non-tax purpose, for example, if it protected theborrower from subsequent interest rate increases.31 In this case, however, Taxpayerderived greater cash flow on an after-tax basis as policy loan interest rates increased. For that reason, Broker’s Date 6, Year 3 letter to Taxpayer indicates that the policies’fixed rate option was fashioned to protect Taxpayer in case interest rates subsequentlydecreased, thereby maintaining Taxpayer’s after-tax rate of return without regard tomarket interest rate fluctuations. It is not surprising, therefore, that Taxpayer wasentitled to annually elect either the fixed or variable rate option and never chose thevariable rate even though market interest rates decreased after the policies becameeffective. Accordingly, contrary to taxpayer’s assertions, the fixed rate provision waspurely tax motivated.

Taxpayer’s third of four arguments is that a revenue ruling and applicable case lawsupport its position that the P1 and P2 plans have economic substance. Taxpayer

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32 The ruling does not provide that every leveraged life insurance transactionthat satisfies the four-out-of-seven test has economic substance per se. Cf. Winn-Dixie, supra, at 292 (explaining that “while the parties agree that [the taxpayer’s] COLIplan meets the four-out-of-seven test . . . section 264 does not confer a right upon [thetaxpayer] to take the deduction that would not otherwise be allowable under section163").

maintains that Rev. Rul. 71-309, 1971-2 C.B. 168, where the Service concluded thatinterest incurred on policy loans was deductible, is controlling. The ruling is similar tothe facts in this case in that the taxpayer in the ruling satisfied the four-out-of-seven testset forth in § 264, and intended to pay the premiums for the eighth and all succeedingpolicy years under a plan that contemplated the systematic borrowing of part or all ofthe increases in the cash value of the policy. Nevertheless, we consider the ruling to beinapposite. The ruling involved one life insurance policy, with the policyholder’s wifeand children designated as beneficiaries. In contrast, the facts in this case involvebroad-based plans comprising many insured lives where it is contemplated that pre-taxcash flows, net of expected death benefits, will be negative over the duration of theplans. The ruling also assumes that, except for the policy loans, no other taxpayer-adverse factors were present. By comparison, in this case, additional factors notpresent in the ruling indicate that the P1 and P2 plans lack economic substance.32

Taxpayer also contends that the Fifth Circuit’s economic substance analysis inCampbell v. Cen-Tex, Inc., 377 F.2d 688 (5th Cir 1967) is applicable to the facts in thiscase. We disagree. In Cen-Tex, the taxpayer was a family-owned corporation thatpurchased leveraged life insurance policies on the lives of its employee-stockholders. On the basis of the parties’ stipulation that the insurance policies in issue werepurchased to meet the taxpayer’s deferred compensation obligations and to provideinsurance on its key employees, the court concluded that the transaction possessedeconomic substance because the transaction produced benefits other than tax benefits. The court in Winn-Dixie, in rejecting the argument that Cen-Tex was controlling,distinguished Winn-Dixie’s COLI transaction by emphasizing the plan’s “predictablenegative cash flow” absent its tax benefits. Winn-Dixie, supra, at 290. Likewise, thecourt in C.M. Holdings distinguished Cen-Tex, by noting that the plan in Cen-Tex waspurchased to provide the taxpayer with insurance protection from financial losses in theevent that its key employees died. C.M. Holdings, supra, at 642. Similar to the plans inWinn-Dixie and C.M. Holdings, the P1 and P2 plans in this case are expected togenerate predictable pre-tax losses over their duration, and are broad-based plans thatare not targeted towards Taxpayer’s key employees. Accordingly, we conclude thatCen-Tex is not controlling in this case.

In addition, Taxpayer cites Shirar v. Commissioner, 916 F.2d 1414 (9th Cir. 1990) asinstructive. Shirar is distinguishable from the facts in this case because the facts inShirar involved one policy purchased to fund potential estate tax liabilities and the

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taxpayer’s plan of purchase contemplated the accumulation of cash value and anexpectation of receiving death benefits in excess of the cost of the policies.

Taxpayer’s last argument is that the Service cannot use Taxpayer’s pattern ofborrowing, which it claims satisfies § 264, as a basis for concluding that the P1 and P2plans lack economic substance for purposes of § 163. Although Taxpayeracknowledges that compliance with § 264 does not ensure deductibility of policy loansunder § 163, Taxpayer contends that the Service cannot use Taxpayer’s decision toborrow heavily from policy values in the eighth policy year as a negative factor inanalyzing the economic substance of the P1 and P2 plans. Taxpayer further arguesthat “Section 264 represents Congress’ decision to draw a clear line between abusiveand permissible borrowing against life insurance policies.”

We disagree. Section 264 only applies to what is otherwise allowable under § 163;thus, a transaction lacking economic substance and business purpose does notgenerate deductible interest under § 163, regardless of whether it meets therequirements of § 264. See C.M. Holdings, supra, at 624; Winn-Dixie, supra, at 292. As indicated by Rev. Rul. 71-309, transactions generating policy loan interest maypossess sufficient economic substance for purposes of § 163 although the taxpayerintends to pay the premiums for the eighth and all succeeding policy years by borrowingfrom increases in the policy’s cash value. Nevertheless, an analysis of thattransaction’s tax-independent economic substance must take such borrowing intoaccount because the borrowing will typically affect the transaction’s non-tax economicconsequences by increasing interest costs and reducing net cash values and net deathbenefits. Therefore, we consider it appropriate to consider Taxpayer’s decision toborrow from the P1 and P2 policies’ cash values during the eighth and all succeedingpolicy years in analyzing the economic substance of the plans. Moreover, other factorsapart from Taxpayer’s particular pattern of borrowing indicate that the P1 and P2 planslack economic substance, including anticipated aggregate pre-tax losses and the policyloan interest rate provisions.

Accordingly, we conclude that Taxpayer’s P1 and P2 plans lack objective economicsubstance, apart from generating tax benefits.

b. Whether the P1 and P2 Plans had a Legitimate SubjectiveBusiness Purpose

We now address whether Taxpayer had a subjective business purpose for engaging inthe P1 and P2 transactions, other than tax avoidance. Taxpayer alleges that, beforeentering into the P1 and P2 transactions, it had become concerned with the increasingpay-as-you-go costs associated with its post-retirement death benefit program, and thatit decided to implement the P1 and P2 plans as a means of paying for such costs. Particularly, Taxpayer contends that, if left “unchecked,” its undiscounted future

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33 Taxpayer’s maximum liability is based on a Year 4 study which assumes thatall current and future employees would be eligible to receive post-retirement deathbenefits. Accordingly, the study sets forth various scenarios depending upon employeepopulation growth rate, attrition, and wage inflation.

liabilities for post-retirement death benefits as of mid-Year 4 could have totaled amaximum of $jj.33

Indeed, both Actuary A’s Date 1, Year 2 letter and Broker’s Date 2, Year 3 proposalindicate that Taxpayer purchased the P1 and P2 plans, in part, to fund its post-retirement death benefit liabilities. Despite Taxpayer’s assertions, however, there is nodocumentation indicating that the anticipated death benefits payable from the P1 andP2 policies were tailored to fund those liabilities. Rather, it appears that Taxpayerstructured the plans in order to pay for its post-retirement death benefit liabilitiesthrough tax savings, rather than death benefits. We first note that the policies remainedin effect even if individual insureds left Taxpayer's employ prior to retirement. Moreover, Actuary B’s projections of cash flows from the plans, completed only oneyear after Taxpayer purchased the P2 plan, indicate that the P1 and P2 policies’anticipated death benefits and net cash values alone would not satisfy Taxpayer'spremium and policy loan obligations. Only when the tax benefits of the interestdeductions are taken into account do the plans generate cash flow to pay forTaxpayer’s liabilities. The “honeymoon letter,” which allowed Taxpayer to terminate theP2 policies in the event Congress enacted new legal restrictions on interest deductions,further indicates that the P2 policies would not provide Taxpayer with satisfactory cashflow absent the tax benefits derived from policy loan interest deductions. See C.M.Holdings, supra, at 640; Winn-Dixie, supra, at 288-289. In this vein, Broker’s Date 2,Year 3 proposal presented to Taxpayer before it purchased the P2 plan sets forth after-tax cash-flow projections for COLI plans issued by various insurers, so that Taxpayercould compare the cumulative net after-tax effects of each plan.

Furthermore, Actuary B’s study also projects that the P1 and P2 plans will generate taxsavings to times greater than was needed to fund Taxpayer’s post-retirementdeath benefit liabilities, and recommends that Taxpayer “utilize some of the extra gainsfor covering the liabilities of other post-retirement programs.” Similarly, Broker’sdocument, “[Sub] Dividend Scenarios,” suggests that Taxpayer, in addition to paying forits retired employee’s death benefits, use the after-tax cash flow from the P1 and P2plans to pay for post-retirement health care costs; executive salary continuation;dividends to Taxpayer’s shareholders; deferred benefits for Taxpayer’s directors; and“other” expenses. In addition, although the P1 and P2 plans were expected to generatemore than enough after-tax cash flow to provide for Taxpayer’s cost of providing post-retirement death benefits, Taxpayer subsequently began recovering that cost from itsratepayers, thereby allowing Taxpayer to use all of the cash flow from the plans forpurposes other than its initial ostensible purpose. These are further indications that

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34 In addition, a letter by Broker to Taxpayer dated Date 13, Year 2, indicatesthat approximately g% of Taxpayer’s employees did not participate in its group lifeinsurance program even prior to the implementation of Taxpayer’s new program on

Taxpayer made little effort to tailor the P1 and P2 plans in an effort to meet its post-retirement death benefit liabilities.

We also note that, even after purchasing the P1 and P2 policies, Taxpayer separatelymaintained a plan operated by Administrator B that administered Taxpayer’s post-retirement death benefit program on a pay-as-you-go basis. Thus, Taxpayer maintainsthat it paid Insurer for insurance in order to fund future payments to Administrator B forcoverage of the same liabilities. Taxpayer, therefore, incurred redundant administrativeexpenses by maintaining two separate insurance plans to pay coverage for the sameliability, i.e., the lives of its retired employees. Were the P1 and P2 policies primarilydesigned to fund Taxpayer’s liability for its employee’s post-retirement death benefits,we doubt that Taxpayer would have needed to maintain its plan with Administrator B.

Taxpayer argues that Actuary B’s Year 4 study does not accurately reflect Taxpayer’sliabilities for post-retirement death benefits as they existed when Taxpayer purchasedthe P1 and P2 plans. Specifically, Taxpayer contends that Actuary B’s estimates ofTaxpayer’s liabilities are not helpful because those estimates incorporate cost-reducingchanges that Taxpayer implemented in its benefit program on Date 12, Year 4,subsequent to the date in which Taxpayer purchased the P1 and P2 plans. Taxpayermaintains that its own Year 4 study, where it estimated its maximum liability at $jj, ismore accurate than Actuary B’s study because Taxpayer’s study projects liabilities onthe basis of Taxpayer’s employee benefit program as it existed when Taxpayerpurchased the P1 and P2 policies.

We disagree. Broker’s Date 2, Year 3 proposal to Taxpayer indicates that, prior topurchasing the P1 and P2 plans, Taxpayer had decided to implement a “new”employee benefit program that would reduce Taxpayer’s liabilities. The proposal furtherexplains that, prior to purchasing the P1 plan, Taxpayer decided to limit eligibility in itsexisting program to employees aged and over, but decided to allow all existingemployees the opportunity to stay in the program due to “moral or perhaps legal agediscrimination” concerns. Accordingly, when Taxpayer purchased the P1 and P2 plans,Taxpayer was also contemplating various cost-reducing changes in its employeebenefits program. Actuary B’s study is the most accurate estimate available ofTaxpayer’s post-retirement death benefit liability, because that study incorporates cost-reducing changes similar to those that Taxpayer was considering at the time that itpurchased the P1 and P2 plans. Given that Taxpayer was anticipating reducingemployee eligibility for post-retirement death benefits when it purchased the P1 and P2plans, we also doubt the reliability of Taxpayer’s own calculated estimates completed inYear 4, which assume that all current and future employees will continue to receivesuch benefits.34

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Date 12, Year 4.

Therefore, we conclude that Taxpayer purchased the P1 and P2 plans to fund itsemployee death benefit liabilities and other unrelated liabilities with the plans’ positiveafter-tax cash flow, which was solely generated by policy loan interest deductions. Accordingly, Taxpayer’s liability for post-retirement employee death benefits is nodifferent than the employee death benefits discussed in Winn-Dixie. Winn-Dixie, supra,at 288. That a taxpayer has a valid use for the after-tax gains generated from atransaction does not confer upon the transaction a valid business purpose. See A.E.P.,supra, at 791-792; Winn-Dixie, supra, at 287. The possibility that the tax benefits fromthe P1 and P2 plans could have been used as a general source of funds for Taxpayer'spost-retirement death benefit obligations, or any other business purpose, does not alterthe fact that the P1 and P2 plan served only to reduce Taxpayer’s income tax liabilities. Accordingly, we conclude that Taxpayer did not engage in the P1 and P2 transactionswith a legitimate business purpose other than tax avoidance.

On the basis of all the aforementioned considerations, we find that Taxpayer purchasedthe P1 and P2 policies pursuant to a plan the only function of which was to generateinterest deductions in order to offset income from other sources and therebysignificantly reduce its income tax liability. We conclude that Taxpayer's broad-basedP1 and P2 plans were shams in substance. Accordingly, Taxpayer is not permitted toclaim interest deductions pursuant to § 163 with respect to interest incurred on P1 andP2 policy loans for Years 11 through 15.

2. Whether Taxpayer paid four of the first seven years’ annual premiums forthe P1 and P2 policies by a means other than indebtedness, therebysatisfying the “four-out-of-seven" safe harbor set forth at § 264(c)(1) andthe accompanying regulations.

The parties dispute whether Taxpayer met the requirements of the four-out-of-sevensafe harbor set forth in § 264(c)(1) with respect to Taxpayer’s premium payments forthe P1 and P2 policies. Since we have concluded that Taxpayer may not claimdeductions for the interest incurred on policy loans because the P1 and P2 plans aresubstantive shams for purposes of § 163, our determination of whether Taxpayersatisfied the four-out-of-seven test will not affect our ultimate conclusion that theinterest incurred on the P1 and P2 policy loans is not deductible. Nevertheless, weshall address whether Taxpayer satisfied the four-out-of-seven test on the assumptionthat the policy loan interest was otherwise legitimate.

Section 264(a)(3) generally disallows deductions for interest paid or accrued on loanstaken against a life insurance policy “pursuant to a plan of purchase whichcontemplates the systematic direct or indirect borrowing of part or all of the increases inthe cash value” of the policy. Section 264(c)(1) provides an exception to this general

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rule. Specifically, § 264(c)(1) provides that if no part of any four annual premiums duein the first seven-year period of an insurance contract is financed by means ofindebtedness, then the general rule of § 264(a)(3) will not apply. The flush language of§ 264(c) further provides that for purposes of applying the four-out-of-seven test, “ifthere is a substantial increase in premiums on the contract, a new 7-year period . . .with respect to such contract shall commence on the date the first such increasedpremium is paid.” See also Treas. Reg. § 1.264-4(d)(1)(i). The legislative history of §264 indicates the Congressional intent underlying § 264(c)(1) and the flush language. In relevant part, the legislative history provides:

The interest deduction is to be allowed if there is no borrowing withrespect to any four of the annual premiums payable on the insurance . . .contract in the first 7 years of the contract. However, to preventavoidance of this provision by taking out a contract with very lowpremiums for the first 4 years, with the premiums being substantiallygreater thereafter, the bill contains a rule relating to situations of this type. It is provided that the 7-year period referred to above is to commenceagain at any time there is substantial increase in the premiums payableunder the insurance . . . contract.

S. Rep. No. 830 (1964), reprinted in 1964-1 C.B. (Part 2) 505, 583 (1964). Thus, theflush language contemplates situations whereby a taxpayer attempts to circumvent themeaning of the four-out-of-seven test by paying four very low annual premiums withoutborrowing, while paying substantially higher premiums for other years with borrowing.

The parties in this case first dispute the effect of the P2 policies’ volume discount uponthe application of the four-out-of-seven test. Since Taxpayer received a volumediscount refund of $kk with respect to the first policy year of the P2 policies, the partiesdispute whether the first policy year’s premium should be measured on a basis net ofthe volume discount for purposes of the four-out-of-seven test. Assuming that the firstpolicy year’s premium is measured on a net basis, the parties also differ as to whethernet premiums for the second policy year represent a substantial increase from the netpremiums payable in the first policy year, thereby triggering a new four-out-of-seventesting period commencing in the second policy year. Since Taxpayer borrowed fromthe P2 policies during the second, third, fourth, and eighth policy years, Taxpayer wouldnot satisfy the four-out-of-seven test if the second policy year’s net premiumsrepresented a substantial increase from the first policy year’s net premiums.

Given the facts of this case, even if we were to accept the argument that it isappropriate to measure premiums on a net basis in applying the four-out-of-seven test,there would not be a “substantial increase” in premiums from the first to second policyyears. The second year’s premiums, net of the Guaranteed Mortality and FluctuationReserve Contingency Refunds, represent only a w% increase over the net premiumsfor the first policy year. There are no similar increases in the net premiums for

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subsequent years, and the premium refunds under the policies are not payable ordeterminable until the end of each policy year. Therefore, the w% increase in netpremiums from the first to second policy years is not a “substantial increase” under §264(c). Accordingly, we reject the argument that the volume discount payable withrespect to the first policy year of the P2 policies precludes the Taxpayer from meetingthe four-out-of-seven test.

The parties next dispute whether the Guaranteed Mortality and Fluctuation ReserveContingency Refunds paid with respect to the second through fourth policy years of theP2 policies should be used to allocate a portion of the loans in those years to the firstpolicy year. Treasury Reg. § 1.264-4(d)(1)(ii) provides in part:

For purposes of subdivision (i) of this subparagraph, if during a 7-yearperiod referred to in such subdivision the taxpayer . . . borrows withrespect to more than one annual premium on a contract, such borrowingshall be considered first attributable to the premium for the current policyyear . . . and then attributable to premiums for prior policy years beginningwith the most recent policy year . . .

An example in the regulations indicates that this provision contemplates situationswhere a taxpayer borrows from a policy an amount in excess of that policy’s “annualgross premium” in the year of the borrowing. See Treas. Reg. § 1.264-4(d)(1)(iv), ex.(1). In such an instance, the loan is first considered attributable to the current year’spremiums, and any excess borrowing is deemed attributable to prior years’ premiums.

Taxpayer’s P2 policy loans for the second through fourth policy years were equal to thegross annual policy premiums for those years, but less than the premiums actually paid,net of the Guaranteed Mortality and Fluctuation Reserve Contingency Refunds. Thus,if we consider the annual premiums for the second through fourth policy years on a netbasis, the loans for such years would exceed such premiums, and the excess would bedeemed as borrowing attributable to the first policy year’s premium. Taxpayer,therefore, would be deemed to have borrowed from the policy for the first four policyyears, and thereby fail the requirements of the four-out-of-seven safe harbor.

We disagree that the premiums for the second through fourth policy years of the P2policies should be viewed net of the Guaranteed Mortality and Fluctuation ReserveContingency Refunds for purposes of Treas. Reg. § 1.264-4(d)(1)(ii). Example (1), setforth at § 1.264-4(d)(1)(iv) of the regulations, suggests that premiums should be viewedon a gross basis for purposes of Treas. Reg. § 1.264-4(d)(1)(ii). This is also consistentwith Treas. Reg. § 1.264-4(c)(1)(ii), which measures certain premium fluctuations interms of “stated annual premiums due on a contract.” These provisions in theregulations were not intended to measure premiums net of experience-based refundsor dividends; otherwise, a taxpayer attempting to comply with § 264 could not be certainthat future contingent refund payments would cause policy loans to fail the four-out-of-

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35 This is distinguishable from a situation where a premium refund is a pre-arranged factual sham. See C.M. Holdings, supra, at 646 (explaining that the premiumfor purposes of the four-out-of-seven test is determined net of loading dividends thatwere determined to be factual shams).

seven test.35 We also note that the Guaranteed Mortality and Fluctuation ReserveContingency Refunds for the second though fourth policy years represented only x% ofthe gross premium due during those years. This is not akin to the situationcontemplated in Example (1) of the Treas. Reg. § 1.264-4(d)(1)(iv), where a taxpayerpays the first four policy premiums without borrowing and essentially borrows fromthose premiums in the fifth policy year by borrowing far in excess of the fifth year’sgross annual premium. Accordingly, we reject the argument that premiums for the P2policies should be viewed on a net basis for purposes of applying Treas. Reg. § 1.264-4(d)(1)(ii). Lastly, the parties dispute whether the fixed policy loan interest rate rider, attached tothe P1 policies in Year 3, Number J months after the policies were issued, results in anew four-out-of-seven testing period for the P1 policies beginning in the second policyyear. Particularly, the parties dispute whether the rider constitutes such a substantialchange in the P1 policies that the policies should be deemed reissued in Year 3. SinceTaxpayer borrowed from the P1 policies during the second, third, fourth, and eighthpolicy years, Taxpayer would not satisfy the four-out-of-seven test if the P1 policieswere deemed reissued in Year 3.

The parties dispute the applicability of cases supporting the principle that, for purposesof § 1001, changes in the interest rates of a debt instrument may result in a taxableexchange of that debt instrument. See, e.g., Emery v. Commissioner, 166 F.2d 27 (2nd Cir. 1948) (holding that exchange of bonds for new bonds with lower interest rates andextended maturity dates was a taxable event). In this case, however, the issue is notwhether the P1 policy loans were exchanged for new loans upon the effective date ofthe fixed rate rider; rather, the issue is whether the P1 policies used to secure policyloans changed so substantially as to commence a new 7-year testing period forpurposes of § 264(c)(1). Accordingly, the cases cited by the parties concerningexchanges of debt instruments are not applicable in the present case.

The legislative history underlying the enactment in 1986 of the $50,000 per policy loanlimitation presently set forth at § 264(e)(1) is helpful. As previously discussed, the$50,000 per policy limitation is not applicable to policies issued prior to June 20, 1986. The following colloquy between Senator Dole and Senator Packwood addresseswhether a policy issued prior to June 20, 1986, will be subject to the $50,000 per policylimitation when certain changes to the policy are implemented after that date:

Mr. DOLE. Section 1003 of H.R. 3838 limits the interest deduction onindebtedness in excess of $50,000 per insured under certain life

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insurance policies. . . . The limitation applies only to indebtedness undercontracts purchased after June 20, 1986.

Concern has been expressed about whether this provision will apply to apolicy purchased on or before June 20, 1986, if the policy is changed in away that was contemplated by the parties and is customary with respect tosuch insurance. I would appreciate confirmation of my understanding thatnone of the following changes to a policy would be treated as thepurchase of a new policy: A change in the owner of the policy, theexercise of an option or a right granted under a contract as originallyissued -- including the substitution of insured but excluding conversion toterm insurance -- or a change in administrative provisions, loan rates, orany other item that does not affect the major terms of the policy. However, a policy exchanged for a policy issued by a different insurancecompany would be treated as a new policy.

Mr. PACKWOOD. Your understanding is correct.

132 Cong. Rec. S13956-57 (Sept. 27, 1986) (emphasis added). Commenting on thiscolloquy, Chairman Rostenkowski further added:

With respect to the colloquies between Senator Dole and SenatorPackwood . . . I am particularly concerned . . . by statements which seemto validate the ability to substitute insureds under a policy and qualifyunder the grandfather provisions. This issue was never discussed, andtherefore never agreed to, by the conferees. In addition, I would like toclarify that certain factual determinations under this provision would bemade by the Internal Revenue Service and the courts.

132 Cong. Rec. E3391 (Oct. 2, 1986)

The legislative history suggests that changes in a life insurance policy will not cause thepolicy to be considered reissued for purposes of § 264(c)(1) unless those changesaffect the fundamental terms of the policy. In this case, the retroactive attachment ofthe fixed rate rider was solely intended to ensure that the P1 policies would generatepolicy loan interest deductions at a rate no lower than the applicable Moody’s rate ineffect when the policies were issued. Taxpayer and Insurer understood that the spreadbetween the loaned crediting rate and the policy loan interest rate would be identicalunder either the variable or fixed rate option; thus, Taxpayer did not generate higher netcash values for any particular year by choosing the fixed rate option over the variablerate option. Therefore, the fixed rate option was not designed to affect Taxpayer’s netcash value in the policies or increase its net death benefits receivable. Although thefixed rate rider may have been tax-motivated, it was not fashioned to avoid theparticular requirements of the four-out-of-seven test. Accordingly, we conclude that the

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retroactive attachment of the fixed interest rate rider to the P1 policies did not result in anew 7-year testing period for purposes of § 264(c)(1).

On the basis of the aforementioned considerations, we conclude that Taxpayer satisfiedthe requirements of the four-out-of-seven safe harbor with respect to its payment ofpremiums for the P1 and P2 policies. Nevertheless, because we also conclude that theP1 and P2 plans were shams in substance, Taxpayer is not permitted to claim interestdeductions on policy loans during the taxable years at issue.

CAVEAT(S)

A copy of this technical advice memorandum is to be given to the taxpayer(s). Section6110(k)(3) of the Code provides that it may not be used or cited as precedent.